Yuan step at a time

The case for a big revaluation of the Chinese currency is weaker than commonly claimed

MANY policymakers and economists argue that the Chinese yuan, pegged for a decade at 8.28 to the dollar, is grossly undervalued, and that a revaluation is essential to reduce America's huge current-account deficit. The issue is likely to be high on the agenda at the next G7 meeting of finance ministers and central bankers on February 4th and 5th, to which China has been invited. Figures last week, showing a further widening of America's trade deficit and a big increase in China's surplus, have surely increased the pressure on China.

However, in a new paper, “To Be a Rock and Not to Roll”, Stephen King, the chief economist of HSBC bank, exposes several myths behind the conventional arguments for a revaluation of the yuan. The first is that China's large and growing trade surplus with America proves that the yuan is undervalued. China's surplus with America is offset by a deficit with other Asian countries (see left-hand chart), from which it imports capital equipment and components. As a result, China's overall trade surplus was a modest $32 billion last year, smaller than in the late 1990s and peanuts compared with America's trade deficit of over $600 billion. Nor does the extraordinarily rapid growth in Chinese exports prove that its currency is too cheap: imports have also been rising rapidly.

But what about the huge increase in China's foreign-exchange reserves, which jumped by almost $100 billion in the fourth quarter of last year? To prevent the yuan rising against the dollar, the People's Bank of China is being forced to buy vast amounts of American Treasury securities. Surely, that proves that the yuan is being held below its market rate? Not necessarily. Much of the increase in reserves reflects inflows of short-term capital, from investors taking advantage of higher interest rates in China or speculating on a revaluation. In the long term, if China scrapped its controls on capital outflows, the yuan might well fall as Chinese households diversified into foreign assets.

It is true that because of its peg to the dollar, the yuan's real trade-weighted exchange rate (adjusted for inflation differences with other countries) has fallen by 13% since 2001. But on a longer view the Chinese currency looks less cheap. Between 1994 and 2001, it gained 30%, dragged up by a rising dollar (see right-hand chart). Those who accuse the Chinese of pursuing a cheap-yuan policy conveniently forget that during the East Asian crisis China let pass the chance to devalue its currency in line with most of its neighbours.

Perhaps the biggest myth of all, says Mr King, is that the yuan's value is the only stumbling block to reducing America's current-account deficit. China accounts for less than 10% of America's total trade so a 10% revaluation of the yuan—as much as might be reasonably expected—would reduce the dollar's trade-weighted value by only 1%. If it were matched by a 10% rise in all other Asian currencies, then the dollar's trade-weighted index would fall by 3.7%. But even that is small compared with the dollar's decline of 16% since early 2002, let alone with what would be needed to cut America's current-account deficit to a sustainable level. Assuming no other policy changes, HSBC estimates that the dollar needs to fall by a further 30% to reduce the deficit to 2-3% of GDP.

Another reason why any plausible revaluation of the yuan would do little to reduce America's trade deficit is that China's exports have a high import content, which limits the impact of exchange-rate movements on export prices. For example, the Chinese value-added (in parts and labour) in a mobile phone exported to America might be only 15% of its price. So a 10% revaluation would raise its price in dollars by only 1.5%.

A lot of hot air

In addition to claims that “China is stealing our jobs”, another popular argument for revaluing the yuan is that the Chinese economy is overheating, because a fixed exchange rate forces the country's authorities to run an overly lax monetary policy. Rising foreign-exchange reserves boost the money supply, causing higher inflation and excessive bank lending. A rise in the exchange rate, it is argued, would give the central bank proper monetary control. The snag is that a small revaluation is likely to increase expectations of another future appreciation, attracting yet more speculative capital and swelling foreign reserves further. To discourage speculation would require a much larger revaluation than the Chinese are likely to accept.

Some economists argue that as China gets richer it needs to allow its real exchange rate to rise, in order to reap the full gains of its economic success. A stronger exchange rate would boost consumers' purchasing power, by allowing them to buy more foreign goods. At present, growth is too dependent on exports, while consumption is weak. However, an increase in the real exchange rate need not require a rise in the nominal rate. Instead it could come about through higher inflation than in countries abroad—as occurred in Japan in the 1950s and 1960s.

Mr King concludes that the biggest problem for China's current exchange-rate policy is not the yuan itself but the performance of the dollar. A fixed exchange rate is supposed to provide stability. So if the dollar continues to fall, China may wish to switch to a more reliable store of value and unit of account. One alternative is a currency basket reflecting the pattern of its trade. China already trades more with the European Union and Japan than with America.

The real blame for America's current-account deficit lies with its lack of saving, not the Chinese yuan. Last year, Li Ruogu, the deputy governor of the People's Bank of China, warned the United States not to blame other countries for its economic difficulties. He said that foreign pressure would not force China to move faster to free its exchange rate. It would indeed be ironic if a change in China's exchange-rate policy came not as a result of American pressure, but from China's own disillusion with the dollar as an international reserve currency.